Fed Raises Rates, Flattens Yield Curve

June 21 2017

Last week, the Fed decided to raise interest rates again, this time from 1 to 1.25%. As we have seen last week (in my article titled “The Keynesian Output Gap Illusion”), this was inevitable according to the Taylor rule, which the Fed still pretends to follow one way or another. Another rate hike later this year is also in the cards. Yet, something surprising happened. Something the Fed would not think possible. And what happened does not bode well for the world’s most important economy.

The Yield Curve Is Flattening

In contrast to what the Fed expects in its models, the exact opposite happened last week. The idea that as the Fed raises short-term rates, long-term interest rates are supposed to rise as well, which all should point to a “healthy” economic recovery, is a complete farce. Inflation expectations are, according to the Fed, “healthy” and there is enough demand for longer durations on capital markets. But the data seem to point at a different direction.

The Fed´s rate hike has, contrary to what was expected, led to a flattening of the yield curve (a yield curve plots bonds from short- to long-dated maturities). And that does not bode well for the economy.

Better said, a “healthy” yield curve is a curve with a big enough gap between the short-term interest rate and long-term interest rate. Likewise, an “unhealthy” yield curve is a curve in which this gap narrows, or a curve that even begins to invert (which means that long-term interest rates begin to exceed short-term interest rates).

Also observe the following chart:

The yield curve is flattening (red: 10-year US Treasury rate minus the 3-month US Treasury rate, blue: 10-Year US Treasury rate minus the 2-year US Treasury rate). Source: St Louis Fed

Above we find the 10-year US Treasury rate minus the 3-month rate (red line) and the 10-year US Treasury rate minus the 2-year US Treasury rate (blue line). What can we observe? The last time the difference between these both rates was this small, was many years ago. Better yet, the last time the difference was this small, was in November 2007 when the US economy was on the verge of a recession (only in the summer of 2016 the difference came anywhere close). In brief, the flattening of the yield curve spells trouble and should make the Fed pause to reflect upon its proposed rate hike trajectory.

A Shift of Power Within the Fed

The Federal Open Market Committee (FOMC) is the committee that used to determine the Fed interest rate. The FOMC consists – in normal circumstances – of twelve members with each one vote. The seven members of the Board of Governors (including its Chair, currently Janet Yellen), the president of the Federal Reserve of New York, and four presidents of the other eleven local Federal Reserves who rotate on an annual basis. Surprisingly enough, the FOMC currently consists of only six members, not eleven. There are three members of the Board of Governors currently missing (the previous ones were not replaced by new appointments, which we will discuss below in further detail) and two presidents of local Federal Reserves (their appointments are also pending).

Now, in theory the FOMC still determines the Fed-rate. The committee determines what the Fed funds rate ought to be. The Fed funds is the rate that banks charge each other for lending and borrowing bank reserves (deposits at the Fed). But this interbank market has been destroyed. And the Fed is responsible for its destruction. By embarking upon that notorious Quantitative Easing (QE) or large-scale asset purchases, the Fed created so many bank reserves that banks are drowning in reserves:

Bank reserves are plentiful, as we can see in this chart which shows the amount of (excess) reserves held by banks on top of the Fed´s reserve requirements. Source: St Louis Fed

The press has apparently missed this entire point, since I read news stories that state things like:

  •  “The Federal Reserve has, as expected, raised interest rates for a third time in six months with 25 basis points to a target range of between 1% and 1.25%” (courtesy of a major Dutch financial newspaper)

The trouble with this is that the Fed funds rate, and thus the FOMC, no longer matters.

Which Interest Rate Does Actually Matter? And Who Determines That Rate?

The answer to the first question (“Which interest rate matters?”) is the rate that the Fed has been paying since 2008 on bank reserves (the IOR rate, in which IOR stands for Interest on Reserves). The answer to the second question (“Who determines that rate?”) is the Board of Governors of the Fed.

Let us first look at this IOR rate. Below you will find this IOR rate (which was raised to 1.25% last week) and the effective Fed funds rate (the rate which the FOMC allegedly determines):

Source: St Louis Fed

This IOR rate functions as a rate ceiling and the reason is simple: there no longer exists an interbank market for bank reserves. Or as Cato Institute´s George Selgin explains:

“Fed officials originally hoped that the interest rate on reserves, and particularly on excess reserves, would serve as a floor on the effective federal funds, because banks would have no reason to lend reserves overnight for less than they could earn by holding on to them: the rate would therefore serve to keep the effective funds rate from reaching its zero lower bound, even if it proved incapable of keeping that rate from falling below the Fed's target.

But that expectation also turned out to be mistaken: because some Government Sponsored Enterprises, including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, kept deposits at the Fed, but weren't eligible for interest payments on those deposits, they were happy to lend their Fed balances to banks overnight at rates below what the banks were earning on their own balances, and the banks were no less happy to oblige them. As the total volume of reserves continued to grow, first in response to further Fed emergency lending, and then in consequence of several rounds of Quantitative Easing, it also became unnecessary for banks themselves to borrow reserves unless they could profit by doing so on the difference between the rate they earned on deposits and the rate they paid on them. The result of all this was that, instead of serving as a floor on the effective funds rate, the interest rate paid on excess reserves ended up becoming a ceiling!”

The IOR rate determines the Fed funds rate. The FOMC has lost control over the Fed funds rate, because the Fed pays interest on reserves and that rate, the IOR rate, is set by the Board of Governors, and not by the FOMC.

The Board of Governors currently consists of four and not seven members, as mentioned earlier: Janet Yellen, Stanley Fischer (who surprisingly invests in gold), Jerome H. Powell and Lael Brainard. There are three vacancies: appointments that Trump has to pull through the US Senate.

These four men (strictly speaking: two men and two women) determine US monetary policy, and not the FOMC, as almost the entire press still presupposes.

There has been a shift of power in fact, ever since 2008, from local Federal Reserve banks to a central authority which is the Board of Governors. This situation is comparable to a situation in which the Dutch central bank loses its voting rights within the ECB Board, to give you an idea. Would that be good news? Most definitely not.

More to Come on the US Economy

The latest US GDP estimate also involves various surprise findings. But more about that later. Whatever the case may be, the US economy is heading for challenging times.

What all this together means, is that the Fed is raising rates at the worst possible moment. The yield curve attests to that. And bad news for the Fed means good news for the gold price.


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